The Gentle Sequestration Slope

By Fisher Investments Editorial Staff, 02/19/2013

The sequester looks big, but it’s not a cliff—and it’s highly unlikely the US economy takes a swan dive off it. Photo by Dean Treml/HO/Getty Images.

With only a couple of weeks to go before their “automatic” March 1 enactment, the federal government’s mandated spending and/or budget cuts—the sequestration—remain. And now it seems the lines of debate are beginning to take shape.

Late last week, Senate Democrats proposed a plan to delay or avert what they suggest are economically damaging cuts. The plan calls for a Buffett Rule-style tax on high earners—a rule eliminating most deductions for high earners and instead installing a 30% minimum tax rate as an alternative to the regular income tax. (Which raises the question: Why do we need another Alternative Minimum Tax?) But leaving such questions aside, the plan would reportedly begin phasing in at a $1 million adjusted gross income, with the rate rising until those earning $2 million or more annually pay the full 30%. The current word is these high earners would be able to deduct charitable contributions, but the Pease rules put back in place in January’s fiscal cliff deal may have already invalidated that claim—after all, many taxpayers who itemize deductions, including charitable contributions, won’t be able to claim them on April 15, 2014. So if you loved the complexity of the US tax code in 2013, this proposal seems right up your alley. If you’re like us and would prefer a vastly simplified tax code, it’s probably not.

In addition, the proposal includes an eight cents per barrel tax on oil extracted from tar sands, whether produced domestically or imported. Since most tar sands production is Canadian, the latter part would seemingly most target them—something Canadian leaders may see as a de facto tariff at odds with the free-trade zone set up under NAFTA.

But realistically, it’s unlikely we’ll ever find out.

Republican leaders have flatly denounced the proposal, rejecting additional tax increases following January’s deal. Hence, the lines are drawn for another debate, though the outcome seemingly carries only a small macroeconomic impact, if any—as was true during the fiscal cliff debates, legislators up for re-election in 2014 have lots of incentive to avoid material tax hikes. And as was also true then, both parties seem keen to avoid the sequester. Only, as Senator Buck McKeon (R-CA) put it, “We just have not been able to get past the politics of it.”

Should politicians not reach a compromise though, as we’ve written, the sequester’s economic impact shouldn’t be as heavy as most portray it. It’s often said the sequestration amounts to $1.2 trillion in cuts over 10 years. (Cue politically charged rants about excessive austerity and/or the benefits of debt reduction.) Of that amount, however, $216 billion is projected interest cost savings due to the projected slower-growing debt. Removing these non-cuts from the headline figure leaves $984 billion in reductions. Yet only in fiscal 2013 will actual year-over-year spending fall. Beyond that point, spending doesn’t fall—it merely rises at a slower rate. Read: Not austere past the first year.

And as also we’ve written, even these cuts are frequently overstated. After adjusting for mandatory spending increases on programs like Social Security and Medicare, the net reduction in spending brought by the sequester is tiny. Shifting government spending away from particular programs and toward others could create winners and losers. But from a macroeconomic or market point of view, the chances the hugely diverse American economy takes a big hit from cuts that amount to a fraction of a percent of GDP are remote.

Again, that’s assuming the sequester happens in full. Given time, it’s very possible a deal will surface. And even if it doesn’t happen before March 1, it’s not as though the sequestration’s impact is immediate.

Since the government spends throughout the fiscal year, the reductions would likely be gradually implemented. So sequestration’s no cliff (not that the fungible fiscal cliff really was), it’s an incredibly gentle slope, providing ample opportunity for politicians to yet again delay cuts, only to rekindle debate at a later, more politically opportune time. After all, the very “automatic” spending cuts we discuss today are the same ones the government can-kicked six weeks ago. The ones created by government 16 months ago because they didn’t cut 90 days prior to then.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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